Wednesday, May 12, 2010

In many ways, the Nasdaq is more efficient than the major stock exchanges because it uses lightning-fast computer linkages, which are typically "open cry" floor models. However, the process associated with bidding for stock and executing a Nasdaq trade is far from perfect. In fact, in spite of the quick "fills", Nasdaq is also known for giving market makers, who make their living trading Nasdaq stocks, ways to fool brokers and investors into thinking that they are truly getting the best execution price, when in fact they are not. For this reason, brokers need to ensure that they and their customers are being treated fairly by being aware of the tricks and gimmicks market makers use.

Trick #1: Giving Phony SizesWhen a trade is called into the floor of the New York Stock Exchange (NYSE), it is immediately routed to a specialist in the stock, who often has limited interest in the individual trade. Because the specialist is being inundated by traders, he simply wants to find a buyer or a seller for your stock as soon as possible. Essentially, he is an intermediary, who sometimes takes positions in stock, but is really there to function as a liquidity provider.

However, Nasdaq market makers, routinely take positions in stocks, both long and short, and then turn them around for a profit, or a loss, later in the day. They provide liquidity, but they are also more focused on capitalizing on your lot of stock by buying it for their own trading account and then flipping it to another buyer. In any case, market makers will sometimes post phony sizes in order to lure you into buying or selling a stock.

For example, market makers may post a bid and an offer that looks something like this:

$10-$10.25 (75x10)

This means that they will buy 7,500 (multiply 75x100) shares of your stock at $10 per share and they will sell 1,000 shares of stock at $10.25. They are obligated under Nasdaq rules to honor those sizes. However, there is a chance that the market maker already owns a position in the stock, and by posting a bid for 7,500 shares, he is merely looking to fool brokers and investors into thinking that there is big demand for the stock and that it is moving higher. (To read more on this subject, see Electronic Trading Tutorial and Markets Demystified.)

Note on this subject: While actions such as this may be frowned upon by the National Association of Securities Dealers (NASD) - they are still fairly common in practice. Also, if someone tries to sell 7,500 shares to the market maker, he must buy them because his bid is posted.

So what happens? Most brokers will simply pay $10.25 for the stock just to get the trade done, but in reality, the purpose of posting a big bid was to sell the market maker's 1,000 shares at $10.25 to the unsuspecting broker. The trick worked! Incidentally, the same trick can be used in reverse on the sell side of the equation. The market maker may show a big offer of say 10,000 shares. Brokers see this, think that the market maker is looking to unload a big block of stock, and quickly sell their shares at the bid price (which, using the above example, is $10). In this case, the trick works again because the market maker fools the broker into selling his shares at $10, precisely where he (the market maker) wanted to buy them.

How to Avoid this Trick: Watch a stock trade before buying or selling it. Learn the players in the stock. By watching the action on a "level 2" or "level 3" screen, you can tell who is accumulating shares or unloading them. With this knowledge, you'll have a better idea of whether the sizes the market maker posts are real. (To learn more, read Introduction To Level II Quotes.)

Trick #2: The Ticket SwitchWhen a broker enters his order, he usually fills out an order ticket and then gives it to a clerk, who then (in theory) executes the order himself, or gives the order to a trader. In doing so, the clerk takes the broker's ticket, time stamps it and attempts to execute the trade. (To continue reading on this subject, see The Nitty-Gritty Of Executing A Trade and Understanding Order Execution.)

However, sometimes the market is moving when this process is going on. In other words, the stock is moving higher (from $10, to $10.12, to $10.25) from the time it takes the broker to get up from his desk and hand the ticket to the clerk. In this case, some clerks will take the ticket, see the stock moving higher and buy the stock at $10.12 for his own, or another broker's, account, and then sell the stock at $10.25 to the broker who originally placed the order. What happens if the stock goes down to $9.75 immediately after the clerk buys it for himself? Although the practice is illegal, the clerk could take the physical ticket, switch the account number on the bottom and tell the original broker he bought the stock at $10.12. Incidentally, market makers will pull this same trick, buying and selling the stock for their own account, using your trade as a cover.

How to Avoid This Trick: Brokers should watch their order entry clerks place the order and wait near the order window to see if they "got a fill". If the transaction is done electronically, correspond with the order clerk, and/or the market maker through your trusted order clerk immediately to see your execution price. Also watch how the stock moves and make sure that nobody is making money off your trade.

Trick #3: Jumping Ahead of Market OrdersWhen a broker places a market order for a stock, he or she is giving instructions to buy the shares at whatever the current price is. This can be a lucrative order for an unscrupulous market maker.

Again, using the same example as before, suppose he is posting a quote that looks like this:

$10-$10.25 (75x10)

If that market maker is getting "hit" with orders, he may sell 1,000 shares at $10.25, then 500 at $10.30, and so on. But seeing your "market order" in his basket of orders to be filled, he knows that you are giving him a carte blanche - in other words, that you are essentially willing to pay any price to get into the stock. And you will.

In most cases, a market maker will make sure that you get filled at a high price (maybe $10.45 a share or higher), and you won't even know it happened! Here's how it works: You saw the stock moving higher and assumed you were last in line, but in reality, the market maker saw your order in the long line of orders and simply bumped up the offer price to accommodate your carte blanche. Working for you are the time-and-date stamps on the physical tickets, a running electronic tally of bids and offers that will help limit occurrences such as these. There's the fact that all these actions are monitored internally at the firm and may be spot-checked by regulators. Despite these safeguards, however, in a stock with high volume, it is hard to prevent and/or prove.

How to Avoid This Trick: Don't place market orders. Use limit orders. In the example above, your order should sound like this: "I want to buy 1,000 shares of XYZ stock at $10.25 or better for the day." This means that the maximum amount you will pay is $10.25, and that the order is good only for this trading day. This will give the market maker fewer opportunities to manipulate you and your client. However, it also means you might miss out on the order should the price rise above your limit.

ConclusionIn short, market makers are trying to make money. It's their job. It's also why you need to keep an eye on your order immediately after the trade is placed. In the long run, both you and your clients will be happy you did.

Glenn Curtis started his career as an equity analyst at Cantone Research, a New Jersey-based regional brokerage firm. He has since worked as an equity analyst and a financial writer at a number of print/web publications and brokerage firms including Registered Representative Magazine, Advanced Trading Magazine, Worldlyinvestor.com, RealMoney.com, TheStreet.com and Prudential Securities. Curtis has also held Series 6,7,24 and 63 securities licenses.